Why the Fed won’t flinch as unemployment drops and inflation rises

First it was the unemployment rate falling faster than the Federal Reserve expected. Now inflation appears to rising more quickly than it anticipated. What’s a central bank to do?

Don’t expect the Fed to raise interest rates soon like it would have done in the past under the very same conditions. The bank will likely decide that neither a falling jobless rate nor rising inflation data are enough to warrant the first rate hike in eight years. There will be some to-and-fro inside the Fed, but Chairwoman Janet Yellen is far from convinced the U.S. economy is ready to experience a post-recession renaissance.

Consider unemployment. As recently as December, the Fed predicted the jobless rate would average 6.3% to 6.6% in 2014. Yet four months into the new year, the rate has already fallen to a five-and-a-half year low of 6.3%. That’s down from 8.2% two years ago and a postrecession peak of 10% in 2009.

The unemployment rate alone, however, fails to tell the whole story about the economy. The U.S., for example, still hasn’t recovered all the jobs lost during the Great Recession. And much of the decline in the unemployment rate stems from people leaving the labor force – the percentage of Americans who have or want a job sits at a 35-year low.

Put simply, senior Fed officials recognize the labor market is not back to normal, and that’s why they no longer use the unemployment rate as the primary measuring stick to determine when to raise interest rates. They are examining a wide variety of indicators to get a pulse on the economy instead.

The most critical indicators focus on inflation, the Fed’s historic nemesis. Yet the recent spike in the consumer price index is also unlikely to sway the Fed that rates need to rise soon.

In April, the annualized ace of consumer inflation over the past 12 months rose to a 14-month high of 2%. Just seven months earlier, the CPI was rising at just a paltry 1.0% annualized rate.

As with the falling unemployment rate, a rising consumer price index is not seen as clear evidence by the Fed that the economy is starting to overheat.

The Fed, for its part, believes the PCE inflation gauge is better gauge of inflation than the consumer price index. And the PCE has risen just 1.1% in the 12 months from March 2013 to March 2014 – well below the 2% rate the Fed considers acceptable.

The central bank has actually been much more worried about falling inflation and most top officials see a mild uptick in prices as a good thing.

The upshot: The Fed will need to see a lot more evidence pointing to an accelerating U.S. economy before it seriously considers an interest-rate increase.